U.S. Gets Caught In The Global Crunch

Emerging markets have taken it on the chin this year, but U.S. investors who piled into them are really feeling the pain. The iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM) has lost 16% of its value since its recent high in January -- and unlike U.S. indexes, which have made all-time highs this year, it's still a third below its 2007 peak. That suggests major emerging markets -- especially the popular BRIC countries -- are in a long-term, secular bear market, leaving little hope for investors counting on outsized returns.

Wall Street's siren song of "buy where the growth is," combined with an aversion to an America supposedly in decline, led many U.S. investors to plow recklessly into emerging markets even as they yanked hundreds of billions from U.S. stocks -- which have handily outperformed EMs for nearly two years. I warned investors that emerging markets had had their day as early as August 2011, and last April we scratched our heads as U.S. investors continued to pile into these former highfliers.

U.S. investors started pouring money into emerging markets during their mid-2000s heyday. According to the Investment Company Institute, around 12% of total equity-fund investments went into EM in 2005 and 2006. But from 2008 through 2012, they bought more than $1 trillion worth of bond funds, while also snapping up $77.7 billion of emerging-market equity funds. And yet investors sold nearly $600 billion -- that's right, $600 billion -- in U.S. equity funds during that same period.

Also, it must be said, many U.S. investors are in a deep funk about their own country -- worried about debt, the U.S. dollar, and the Federal Reserve's extraordinarily loose monetary policy. That has led them to overinvest in precious metals, foreign currencies, and emerging-market stocks and bonds while avoiding the U.S. like the plague. Their pessimism, of course, couldn't be more poorly timed. That's because from October 2011 through May 2013 the Wilshire 5000 Total Market Index has rallied 53.8%, more than double the MSCI Emerging Markets Index's 24.5% gain.

Emerging Markets' Secular Bear

Why? Because some of the biggest emerging markets have been in secular bear markets for some time. That's been entirely lost on Wall Street, but William Smead, CEO and chief investment officer of Smead Capital Management in Seattle, said commodities and emerging markets entered a secular bear market in August 2011. That's just around the time emerging and U.S. stocks diverged.

I think China has been in a Japan-like permabear market since 2007, when the Shanghai Composite index hit 6,000. It now sits at around 2,000 and will reach its 2007 high again when they play golf on Neptune. Brazil, which profited mightily from China's rise, probably saw its Bovespa index peak over 72,000; it now sells at 47,000. Brazil is plagued by a weak real, much slower growth, massive protests against the government,and China's slackening demand for commodities and resources. And of course Russia, whose success was based entirely on its oil and gas reserves, will see its stock market languish as the commodity supercycle has turned into a long-term bear. That's significant because those three BRIC countries alone comprise 35% of the EEM ETF, while another 26% comes from developed Korea and Taiwan, whose economies are growing more slowly than the U.S.

"For the last five years, American investors have poured money into emerging markets, bond funds, gold," Smead told me -- all part of what he called a "massive misallocation of capital ... by institutions and high-net-worth individuals in the United States." As a result, he said, U.S. stocks are substantially underowned in individual and institutional portfolios, while investors hold far too much in emerging markets.

"Does it make sense for a U.S. citizen to have 10% of [his or her] portfolio in emerging markets? It does not," said Smead. That's why I would sell general emerging market ETFs like EEM (which I own) or Vanguard FTSE Emerging Markets ETF (VWO) on any big rallies. You probably get enough exposure in broad international index funds like Vanguard Total International Stock ETF (VXUS), of which emerging markets comprise 20%. If you want a bit more, I'd buy small positions in strong emerging markets that are not in secular bear markets, like the iShares MSCI Mexico Capped Investable Market(NYSEARCA:EWW) and the iShares MSCI Malaysia Index (NYSEARCA:EWM).

When the history books about this era are written, they will surely note that U.S. investors abandoned their own country's stocks at just the wrong time, and poured money into emerging markets long after the bloom was off the rose. Wall Street hype played its part, but for investors who embraced the anything-but-American-stocks mentality, this will be yet another lesson learned the hard way.

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